SAN PEDRO COLLEGE

12 C. Guzman Street, 8000 Davao City, Philippines

Master of Arts in Hospital Administration

Third Trimester, SY 2019-2020

ACCOUNTING & FINANCIAL MANAGEMENT

LESSON 2 – RELEVANT COSTING

THE DECISION-MAKING PROCESS

1. Definition of the DECISION PROBLEM.

2. Identification of the DECISION CRITERIA.
3. Selection of possible ALTERNATIVE COURSES OF ACTION.
4. Collection of the RELEVANT DATA and assessment of its quantitative and
qualitative factors involved in each alternative.
5. Formulation of a DECISION by selecting the best alternative.

Limitations of the Decision-Making Process:

a. Insufficiency or excessiveness of information.
b. Misidentification of the decision problem.
c. Overconfidence in the decision outcome.

IDENTIFY RELEVANT COSTS & BENEFITS

Costs that differ between alternatives are relevant in a decision. All other irrelevant
costs and benefits should be ignored. In addition, managers need different costs for
different purposes.

1. RELEVANT COST and IRRELEVANT COST –

The former refers to future differential costs, while the latter refers to the
cost that neither varies in amount from one alternative to another nor
involves incurrence in the future.

2. DIFFERENTIAL COST and MARGINAL COST –

The former refers to the difference in cost between two alternatives, while
the latter refers to the increase in total cost arising from the production or
sale of additional unit of a product.

3. DIRECT COST and INDIRECT COST –

The former refers to the cost which can be directly attributable to a product,
service, or department while the latter refers to the cost which is allocated to
other product, service or department.
 4. AVOIDABLE COST and UNAVOIDABLE COST –
The former refers to the cost that can be eliminated by choosing one
alternative over another, while the latter refers to the cost that would be
incurred regardless of chosen decision.

5. OUT-OF-POCKET COST and SUNK COST –

The former refers to the cost which are to be incurred in the future, while the
latter refers to the cost which are already incurred in the past decisions and
cannot be avoided regardless of what a manager decides to do.

6. OPPORTUNITY COST and IMPUTED COST –

The former refers to the potential income or benefit foregone by choosing
another alternative, while the latter refers to the value assigned to an item
but which has not been the result of any transaction.

APPROPACHES IN ANALYZING ALTERNATIVE IN NON-ROUTINE DECISION

MAKING

1. TOTAL APPROACH – considers all costs, whether relevant or not.

2. INCREMENTAL APPROACH – considers only relevant costs.

Both approaches yield the same results. The best approach to use depends on
information availability. If the required information is available for both alternatives,
use the total approach for a better and clearer information. Using both approaches
are also better for comparison and validation of answers and solutions if enough
time is available.

TYPES OF SHORT-TERM DECISION

1. MAKE or BUY –

Cost to Make Cost to Buy

Direct materials xx
Direct labor xx
Variable manufacturing overhead xx
Fixed manufacturing overhead
(savings foregone) xx
Opportunity cost (profit foregone) xx
Purchase price __ xx
Total relevant costs xx xx

Decision Criteria:
If Cost to Make ˃ Cost to Buy, then choose Buy.
If Cost to Make ˂ Cost to Buy, the choose Make.

Note: Selling & administrative expenses, whether variable or fixed,

are assumed irrelevant except they vary across alternatives.
Illustration:

Sylistic Guitar Center produces a premium multifunctional acoustic guitar

that is far superior to other guitars on the market. It currently sells 200 units
of acoustic guitar for P4,400 per unit. The company is considering acquiring
the acoustic guitars from JR Guitar Company, a manufacturer of custom-
made guitars. The costs incurred in the production of acoustic guitars are as
follows:
Per unit Total
Materials (wood) P1,000 P200,000
Salary of luthier (guitar maker) 1,500 300,000
Variable overhead (strings, glue, sealer) 500 100,000
Fixed overhead 600 120,000
P3,600 P720,000
JR Guitar Company is offering to sell the guitars to Stylistic Guitar for P3,400
per unit.

Required:

1. Based on the above assumptions, which decision is better for the

management and by how much is the savings?

Answer – Make, savings of P80,000.

Solution –
Make Buy
Direct materials (P1,000 x 200) P200,000
Direct labor (P1,500 x 200) 300,000
Variable manufacturing overhead
(P500 x 200) 100,000
Purchase price (P3,400 x 200) ________ P680,000
P600,000 P680,000

Net savings/ advantage of producing guitars P80,000

2. Assume that Stylistic Guitar could save up to P90,000 of fixed overhead

from its current leasing of a woodworking equipment if it chooses to buy
guitars from JR Guitar, which decision is better for the management and
by how much is the savings?

Answer – Buy, savings of P10,000.

Solution –
Make Buy
Direct materials (P1,000 x 200) P200,000
Direct labor (P1,500 x 200) 300,000
Variable manufacturing overhead
(P500 x 200) 100,000
 Make Buy
Fixed manufacturing overhead
savings – opportunity foregone 90,000
Purchase price (P3,400 x 200) ________ P680,000
P690,000 P680,000

Net savings/ advantage of buying guitars P10,000

3. Assume that instead of saving up P90,000 fixed overhead from leasing a

woodworking equipment, Stylistic Guitar could rent out for P100,000 the
building space that it used to manufacture guitars, which decision is
better for the management and by how much is the savings?

Answer – Buy, savings of P20,000.

Solution –
Make Buy
Direct materials (P1,000 x 200) P200,000
Direct labor (P1,500 x 200) 300,000
Variable manufacturing overhead
(P500 x 200) 100,000
Purchase price (P3,400 x 200) P680,000
Rental of unused building space
- opportunity cost 100,000 ________
P700,000 P680,000

Net savings/ advantage of buying guitars P20,000

4. Before making the final decision, Stylistic Guitar’s management will have
to assess the qualitative factors of either making or buying the guitars.
Identify some of these factors.

Answer –
a. Quality of guitars
b. Future technological advancements of the guitars
c. Commitment of guitar suppliers
d. Potential income of leasing out or using the unused
building space
ADDING or DROPPING PRODUCTS/ SEGMENTS –

Incremental loss on revenues if dropped (xx)

Less: Incremental savings on costs if dropped:
Variable costs xx
Avoidable fixed costs xx
Opportunity cost (profit foregone) xx
Incremental decrease in profit if dropped (xx)

Decision Criteria:
If Avoidable Fixed Costs is ˃ Contribution Margin, then choose Drop the
product or segment.
If Avoidable Fixed Costs is ˂ Contribution Margin, then choose Continue
the product or segment.

Note: In case of adding products/ segments, contribution margin must

be greater than avoidable fixed costs.

Illustration:

Ace International has three major product lines – homewares and decors,
stationery and craft, and health and beauty. The latest income statements
of the product lines are given below:

Product Line _
Homewares Stationery Health &
Total & Decors & Craft Beauty
Sales P2,500,000 P1,250,000 P750,000 P500,000
Variable expenses 1,050,000 500,000 250,000 300,000
Contribution margin P1,450,000 P 750,000 P500,000 P200,000
Fixed expenses:
Salaries & wages P 500,000 P 295,000 P125,000 P 80,000
Marketing 150,000 10,000 75,000 65,000
Utilities 20,000 5,000 5,000 10,000
Depreciation 50,000 10,000 20,000 20,000
Rentals 200,000 100,000 60,000 40,000
Insurance 30,000 20,000 5,000 5,000
General admin 300,000 150,000 90,000 60,000
Total fixed expenses P1,250,000 P 590,000 P380,000 P280,000
Net profit (loss) P 200,000 P 160,000 P120,000 (P80,000)
The management analyzed the fixed costs being charged to the three
product lines as follows:
a. Salaries and wages – represent the labor paid to employees working
directly on the products. All of the employees working in the health and
beauty would be discharged if the product line is dropped.
b. Marketing – represents the advertisements and promotions that are
specific to the product line and are avoidable if the line is dropped.
c. Utilities – represent the light, water and communication costs for the
entire company. They are allocated to the product line based on space
occupied and are not avoidable if the product line is dropped.
d. Depreciation – represents the depreciation on furniture and fixtures
used to display the various product lines which do not have resale value
even if the health and beauty is dropped.
e. Rentals – represent the noncancelable, long-term lease on the entire
building of the company which is allocated based on the area size.
f. Insurance – represents insurance premiums carried on inventories of
each three product lines. If a product line is dropped, the related
inventories will be liquidated and the premiums will decrease
accordingly.
g. General administrative – represents the costs of accounting, purchasing
and general management, which are allocated to the product lines. Such
costs will not change if the product line is dropped.

Required:

1. With the above information, should production and sale of health and
beauty be dropped?

Answer – No, dropping the product line will incur additional loss of
P50,000.
Solution –

Incremental loss on revenues (500,000)

Less: Incremental savings on costs:
Variable costs 300,000
Avoidable fixed costs (80,000
+ 65,000 + 5,000) 150,000
Incremental decrease in profit ( 50,000)

Based on the computation, the company would suffer

additional loss of P50,000 if it decides to drop the health and
beauty product (h &b) line.
 The extra loss of P50,000 can also be analyzed as follows:
Effect
Keep Drop on
H&B H&B Profit
Sales P500,000 - (P500,000)
Variable expenses (300,000) - 300,000
Contribution margin P200,000 - (P200,000)
Avoidable fixed expenses:
Salaries & wages P 80,000 P 80,000
Marketing 65,000 65,000
Insurance 5,000 5,000
Total (P150,000) P150,000
Segment margin P 50,000 (P50,000)
Allocated fixed expenses:
Utilities P 10,000 P 10,000
Depreciation 20,000 20,000
Rentals 40,000 40,000
General admin 60,000 60,000 ___-____
Total P130,000 (P130,000) - _
Net profit (loss) (P80,000) (P130,000) (P50,000)

2. Indicate some of the qualitative factors that the company must consider
before dropping the product line.

Answer –
a. Introduction of a new profitable product line
b. Attractiveness of the product line to customers

Illustration:

The Flint Fan Company is considering the addition of a new model fan, the F-
27, to its current product lines. The expected cost and revenue data for the
F-27 fan are as follows:
Annual sales 4,000 units
Unit selling price P58
Unit variable costs:
Production P34
Selling P4
Avoidable fixed costs per year:
Production P20,000
Selling P30,000
If the F-27 model is added as a new product line, it is expected that the
contribution margin of other product lines at Flint will drop by P7,000 per
year.
Required:

1. If the F-27 product line is added next year, how much is the change in
operating income?

Answer – Net increase of P23,000.

Solution –

Incremental sales (58 x 4,000) P232,000

Less: Incremental costs:
Variable costs (38 x 4,000) (152,000)
Avoidable fixed costs (20,000
+ 30,000) ( 50,000)
Incremental increase in profit 30,000
Decrease in contribution margin of other
product lines (opportunity cost) ( 7,000)
Net increase in operating income P 23,000

2. What is the lowest unit selling price that could be charged for the F-27
model and still make it economically desirable for Flint to add the new
product line?

Answer – P52.25
Solution –

Incremental costs:
Variable costs P38.00
Avoidable fixed costs
( 50,000/ 4,000) 12.50
Decrease in contribution margin
of other product lines (7,000/ 4,000) 1.75
Lowest unit selling price P52.25
SELL “AS IS” or PROCESS FURTHER –

Sales value after further processing xx

Less: Sales value at the split-off point (xx)
Incremental revenue from further processing xx
Less: Incremental processing costs incurred
after the split-off point (xx)
Incremental increase in profit if processed further xx

Decision Criteria:
If Incremental Revenue ˃ Incremental Cost of Processing, then choose
Process Further.
If Incremental Revenue ˂ Incremental Cost of Processing, then choose
Sell at Split-off Point

Note: Joint or common costs are treated as irrelevant costs.

Illustration:

Renaissance Wool Company buys raw wall from local sheepherders,

separates the wool into three grades – coarse, fine and superfine, and then
dyes the wool using traditional methods that rely on pigments from local
materials. A diagram of the production process is shown below:
Required:

1. What is the overall profit if all intermediate products are processed into
final products?

Answer – P20,000
Solution –

Combined final sales value

(170,000 + 250,000 +100,000) P520,000
Less: Cost of producing the end products
Joint costs (300,000 + 50,000) 350,000
Additional processing costs
(60,000 + 70,000 + 20,000) 150,000
Overall profit P 20,000

2. What is the profit from further processing each of the intermediate

products?

Answer – Coarse Wool (loss of P20,000), Fine Wool (profit of

P20,000), and Superfine Wool (profit of P10,000)
Solution –

3. If your recommendation is followed, what should be the overall profit

of the company?

Answer – P40,000
Solution –

Combined final sales value

(130,000 + 250,000 +100,000) P480,000
Less: Cost of producing the end products
Joint costs (300,000 + 50,000) 350,000
Additional processing costs
(70,000 + 20,000) 90,000
Overall profit P 40,000
TEMPORARY SHUTDOWN or CONTINUE –

Incremental loss on revenues if shutdown (xx)

Less: Incremental savings on costs if shutdown:
Variable costs xx
Avoidable fixed costs xx
Incremental decrease in profit if shutdown (xx)

Decision Criteria:
If Avoidable Fixed Costs is ˂ Contribution Margin, then choose Continue
the business operation.
If Avoidable Fixed Costs is ˃ Contribution Margin, then choose Temporary
Shutdown of the business operation.

The shutdown point (indifference point) is that estimated sales, in pesos or

units, that must be generated in order to equal the loss to be incurred if
business operations were discontinued. It can be formulated as:

Sales at Shutdown Point(p) = Fixed Costs – Shutdown Costs*

Contribution Margin Ratio

Sales at Shutdown Point(u) = Fixed Costs – Shutdown Costs*

Unit Contribution Margin

* Shutdown costs refer to the costs, such as security and maintenance and
other unavoidable costs, that the company will continue to incur even
when there is no operation.

Illustration:

Phoelab Company plans to discontinue a department that has a

contribution margin of P24,000 or P4.00 per unit. Its sales are P60,000 and
fixed costs are P48,000. Of the fixed cost, P21,000 cannot be eliminated.

Required:

1. Should the company temporarily shutdown or continue its operation?

Answer – Continue its business operation.

 Solution –

Incremental loss on contribution margin if

shutdown (P24,000)
Less: Avoidable fixed costs
(48,000 – 21,000) 27,000
Incremental increase in profit if shutdown P 3,000

2. How many units is currently sold?

Answer – 6,000 units

Solution –

Sales = P24,000/ P4.00 per unit

3. How much is the shutdown costs?

Answer – P21,000

4. What is the shutdown point?

Answer – P67,500 or 6,750 units

Solution –

Sales at Shutdown Point(p) = P48,000 – 21,000 = P67,500

40%*

* sales 60,000 10 100%

less: variable cost 36,000 6 60%
contribution margin 24,000 4 40%

Sales at Shutdown Point(u) = P48,000 – 21,000 = 6,750

P4

5. What are the possible qualitative factors to consider before shutting

down temporarily?

Answer –
a. Shortage in materials and other supplies
b. Labor unrest
c. Effect on company’s image
d. Loss of customer’s confidence
ACCEPT OR REJECT SPECIAL SALES ORDER –

Incremental revenues from special order xx

Less: Incremental costs from special order:
Direct materials xx
Direct labor xx
Variable manufacturing overhead xx
Variable selling and administrative xx
Additional variable costs* xx
Opportunity cost (profit foregone) xx (xx)
Incremental profit from special order xx

* design cost, overtime cost, subcontracting cost, etc.

Decision Criteria:
If Special Order Price is ˃ Avoidable Costs plus Opportunity Costs, the
choose Accept the special order.
If Special Order Price is ˂ Avoidable Costs plus Opportunity Costs, the
choose Reject the special order.

A special order is a one-time order that is not considered part of the

company’s normal business operations.

If the company has excess production capacity, the minimum selling price is
equal to the relevant variable costs if the special order is rejected. If,
however, the company is operating at full production capacity (no excess
capacity for the special order), the minimum selling price is equal to the sum
of the relevant variable costs and opportunity costs (contribution margin to
be lost from regular customers).

Illustration:

Atom Company is a manufacturer of electronic switches. One of their

products, “Sensory Switch,” is used as a component of most electrical
appliances.

Sensory Switch has the following financial data per unit:

Selling price P180
Variable costs: Materials P24
Labor 18
Factory overhead 15
Shipping and handling 3 60

Fixed costs: Factory overhead P36

 Selling and administrative 14 50
Total P110
During the month, Atom has received a special, one-time order for 1,500
units of Sensory Switch.

Required:
1. Assuming that the company has excess capacity that is enough to
produce this special order without affecting sales to regular customers,
and the company wants to improve its profitability, the price that is
acceptable for this special, one-time order in excess of what amount?

Answer – P60.00 per unit

Solution –

Incremental revenues from special order xx

Less: Incremental costs from special order:
Variable manufacturing costs
(24 + 18 + 15 + 3) 60
Incremental profit from special order xx

2. Assume that Atom is operating at full capacity and that it does not want
to incur a loss from this order, the minimum acceptable price is what
amount?

Answer – P180.00 per unit

Solution –

Incremental revenues from special order xx

Less: Incremental costs from special order:
Variable manufacturing costs
(24 + 18 + 15 + 3) 60
Opportunity cost on lost sales
(180 – 60) 120 180
Incremental profit from special order xx

3. Assume that the excess capacity available for the special order is only
1,000 units, so that if the order were accepted, Atom would have to
reduce sales to regular customers. What is the minimum price for this
special order?

Answer – P100.00 per unit

Solution –
 Incremental revenues from special order xx
Less: Incremental costs from special order:
Variable manufacturing costs
(24 + 18 + 15 + 3) 60
Opportunity cost on lost sales
(180 – 60 = 120 x 500/1,500) 40 100
Incremental profit from special order xx

4. What are the qualitative factors that Atom Company should consider
before making a decision on whether to accept or reject a special sales
order?

Answer –

a. Excess or idle production capacity

b. Production capability of existing machinery, labor and
facilities
c. Impact on customers relations such as delivery delays and
special-order pricing
QUIZ – RELEVANT COSTING

Multiple Choice:

1. In decision-making case, which of the following costs is generally not relevant to the
decision?
a. Avoidable cost
b. Historical cost
c. Opportunity cost
d. Differential cost

2. In a decision-making case, which of the following cost is not likely to contain a

relevant cost component?
a. Labor cost
b. Selling cost
c. Depreciation cost of an existing asset
d. Factory overhead cost

3. Arce currently works as the fry guy at Burger Machine but is thinking of quitting his
job to attend college full time next semester. Which of the following would be
considered an opportunity cost in this decision?
a. the cost of the textbooks
b. the cost of the cola that Arce will consume during class
c. Arce's lost wages at Burger Machine
d. both A and B above

4. In a make-or-buy decision, relevant costs include:

a. unavoidable fixed costs
b. avoidable fixed costs
c. fixed factory overhead costs applied to products
d. fixed selling and administrative expenses

5. In a decision-making analysis involving a question on whether to continue or

discontinue selling a product or operating a business segment,
a. the avoidable revenues should be removed with the avoidable costs.
b. the product or business segment whose total cost is greater than its revenue
should be discontinued.
c. all fixed costs are irrelevant.
d. the product or business segment that has a positive contribution margin should
not be discontinued.

6. Which of the following is not relevant to a decision about whether to drop a segment
or not?
a. The available fixed costs direct to that segment
b. The contribution margin expected to be earned by the segment
c. The complementary effects of discontinuing the segment
d. The indirect cost allocated to the segment
7. Two or more products produced from a common input are called:
a. common costs.
b. joint products.
c. joint costs.
d. sunk costs

8. Product X-547 is one of the joint products in a joint manufacturing process.

Management is studying whether to sell X-547 at the split-off point or to process X-
547 further into Xylene. The following data have been gathered:
I. Selling price of X-547
II. Variable cost of processing X-547 into Xylene.
III. The avoidable fixed costs of processing X-547 into Xylene.
IV. The selling price of Xylene.
V. The joint cost of the process from which X-547 is produced.
Which of the above items are relevant in a decision of whether to sell the X-547 as is
or process it further into Xylene?
a. I, II, and IV.
b. I, II, III, and IV.
c. II, III, and V.
d. I, II, III, and V.

9. A company is considering to accept a special order which will enable it to use its
currently idle capacity. It wants to conduct a differential cost analysis so it could set
the special price for the order. In its cost analysis, which of the following should not
be included?
a. Variable overhead
b. Direct labor
c. Direct materials
d. Depreciation

10. One of Giga Core Computer’s products is Z-Card. The company currently produces
and sells 30,000 Z-Cards per month, although it has the plant capacity to produce
50,000 units per month. At the 30,000 units-per-month level of production, the
average per-unit cost of manufacturing Z-Cards is P45, consisting of P15 in variable
costs and P30 in fixed costs. Giga Core sells Z-Cards to retail stores for P90 each.
Computer Galaxy has offered to purchase 10,000 Z-Cards per month at a reduced
price. Giga Core can manufacture these additional units with no change in fixed
manufacturing costs.

In deciding whether to accept this special order from Computer Galaxy, Giga Core
should be at least concerned with:
a. what Computer Galaxy intends to do with the Z-Cards.
b. the P45 average cost of manufacturing Z-Cards.
c. the opportunity cost of not accepting the order.
d. the incremental cost of manufacturing an additional 10,000 Z-Cards per month.
CASE PROBLEMS

Case 1

Blaze Corporation makes motorcycle engines. The company’s records show the
following unit costs to manufacture part 143:
Direct materials P120
Direct labor 150
Variable overhead 200
Fixed overhead 100
Another manufacturer has offered to supply Blaze Corporation with part 143 for a cost
of P500 per unit. Blaze uses 1,000 units annually.

Required: If Blaze accepts the offer, what will be the short-run impact on
income? __________________

Case 2

Reflexive Company needs 10,000 units of a certain part to be used in production. If it

buys the part from Static Company instead of making it themselves, it could not use
the present facilities for another manufacturing activity. Sixty percent of the fixed
overhead applied will continue regardless of what decision is made. The following
quantitative information is available regarding the situation presented:
Cost to make the part:
Direct materials P 60
Direct labor 240
Variable overhead 120
Fixed overhead applied 150
P570
Cost to buy the part P530

Required:
A. In deciding whether to make or buy the part, what are Reflexive’s total relevant
costs to make the part? __________________
B. Which alternative (make or buy) is more desirable for Reflexive and by what
amount? __________________
C. Suppose that Reflexive is in an area of the country with high unemployment and
that it is unlikely that displaced employees will find other employment. How might
that impact your decision? __________________

Case 3

The following data pertain to the three products being produced and sold by Xenon
Corporation in a typical month:
 The company’s lease contract will expire at the end of the current month, and the
lessor does not want to renew the contract. As a result, Xenon Corporation must
move to another facility. It has found a new, smaller place which the company will
start occupying next month. Since the new place is smaller, one of the products has
to be eliminated and the total allocated fixed cost would be reduced by 30%.

Required:
A. Which product should the company eliminate? __________________
B. After eliminating the appropriate product, what was the company’s net profit (loss)
before tax? __________________

Case 4

Determine which of the following products may the company process further:

Required: How much is the relevant cost in the additional processing of Product
A? __________________

Case 5

Hardwood Furnitures makes unfinished furniture for sale to customers from its own
stores. Recently, the company has been considering taking production one additional
step and finishing some of the furniture to sell as finished furniture. To analyze the
problem, the company is going to look at only one product, a very popular dining
room chair. The chair can be produced now for P650 and sells for P850 unfinished. If
the company were to finish the chair, the cost would increase to P900, but the
company could sell the finished chairs for P1,250.

Required: Should Hardwood finish the chairs or continue to sell them unfinished?
__________________
Case 6

Aster Company incurs fixed costs and expenses of P50,000. Its product sells for P100
each, and incurs variable cost per unit of P60. Current market sales yield 300 units. If
the company closes shop temporarily, fixed cost savings are estimated to amount to
P20,000, but additional costs for security and maintenance of P6,000 have to be
incurred.

Required: Should the company temporarily shutdown or continue its operation?

__________________

Case 7

Finer Corporation has considerable excess capacity. During the month, it received a
special order at a price much lower than its regular price. The special order’s cost
sheet shows the following:
Materials P8,000
Labor 12,000
Applied factory overhead costs:
Variable 35,000
Fixed 20,000
The applied fixed factory overhead cost includes an allocated P5,000 for in-house
design costs, although no in-house design cost will be done for the special order.
Instead, the job will require the use of external designers for which the company will
incur P7,000.

Required: What is the total amount to be included in the calculation to determine

the minimum acceptable price for the special order?
__________________